Often Overlooked Tax Break: Unreimbursed Business Expenses

December 31, 2010

If you are an employee or member of a business partnership with unreimbursed out-of-pocket business expenses, you may be entitled to a tax deduction on your individual tax return (Form 1040). Types of unreimbursed expenses can include overnight travel, transportation that exceeds the daily commuting distance, vehicle expenses, 50% of business meals, and other job-related expenses.

When it comes to out-of-pocket business expenses, employers can decide to reimburse expenditures through either an accountable plan or non-accountable plan. An accountable plan is where an employer reimburses business expenses paid out-of-pocket upon submission of substantiation (expense report) compared to a non-accountable plan where an employer provides the employee with an allowance for business expenses and does not require the employee to provide documentation to support the expenditure.

Where do I Claim Unreimbursed Business Expenses?

1. Employee

Various employers tend to have policies where they only reimburse employees a certain amount of out-of-pocket expenses or do not reimburse any expenses. This is common in the real estate, stock brokerage, or business development professions. Unreimbursed business expenses are claimed on 1040 Form 2106, ‘Employee Business Expenses.’

Example 1- Employees reporting unreimbursed business expenses on Form 2106

Bob an employee of ABC Company incurred $25,000 of various out-of-pocket expenses in 2010. ABC Company’s corporate policy is to reimburse only up to the first $5,000 of out-of-pocket expenses pursuant to an accountable plan.  On Form 2106, Bob would report his $25,000 of expenses and also report the $5,000 of employer reimbursements. Any meals and entertainment expenses would further be limited to 50% of the actual cost.

After reporting the unreimbursed expenses on Form 2106, the net amount of business expenses are carried forward to Form Schedule A, ‘Itemized Deductions’ where these amounts would be categorized as “Miscellaneous Itemized Deductions” and are subject to a 2% phase out of Adjusted Gross Income (AGI).

Example 2- Employee business expenses flow-through to Schedule A

Continuing with the previous example, Bob carries over $20,000 of business expenses from Form 2106 to Schedule A. Bob reported his AGI to be $400,000 on page 1 of his 1040. The amount of business expenses Bob can deduct would be reduced by 2% of AGI ($8,000) giving him a new total of $12,000 in business deductions.

Deductible business expenses can be further reduced or completely phased out should a taxpayer be subject to Alternative Minimum Tax (AMT). When a taxpayer is in AMT, unreimbursed business expenses and other miscellaneous itemized deductions are added back to income thus increasing taxable income and potentially increasing the tax liability. Between the 2% phase out of AGI and add back to AMT, it is important that you see whether or not your out-of-pockets expenses will be tax beneficial before spending the time to gather receipts and possibly have no tax deduction to show for it.

2. Partner

Taxpayers who are members of a partnership tend to have a favorable treatment of out-of-pocket expenses.  When a partner receives a K-1 from his or her partnership, the income reported on that form passes through to the 1040 on Form Schedule E, ‘Supplemental Income and Loss.’ Any partnership expenses paid from the partner’s personal funds can be used to offset the pass-through income being reported. Claiming business expenses against partnership income reduces both taxable income and the self-employment tax.

Example 3- Partner uses out-of-pocket expenses to reduce income reported on Schedule E

Jo Ann has $120,000 of pass-thru ordinary income from a business consulting firm. If Jo Ann had $15,000 of out-of-pocket partnership expenses, she can offset the expenses against the $120,000 of partnership income. Jo Ann’s earned income is reduced to $105,000 and saves her $2,295 ($15,000 x 15.3%) in self-employment tax not subject to phase out of AMT.

S Corporation shareholders may not use their out-of-pocket expenses to directly reduce their share of the corporation’s income. Shareholders are categorized as employees of the corporation and must further claim their unreimbursed expenses as a miscellaneous itemized deduction as described above.

How do I document my business expenses?

Adequate records of all out-of-pocket travel and entertainment expenses must be maintained in order to claim a deduction. Additional documentary evidence is required for all travel and entertainment expenses in excess of $75. Documenting these expenditures is required to provide business sufficiency should the Internal Revenue Service (IRS) ask for it if upon audit. In order for a travel or entertainment expenditure to be allowable, the following information must be provided with each expense:

  1. Date of the travel or entertainment
  2. Place where the expense was incurred
  3. The business purpose of the expenditure
  4. Business relationship between you and anybody you entertained
  5. The amount of the expense
  6. Vehicle: Same as above plus number of miles driven
  7. All other expenses (postage, dues, etc.) – receipt, proof of payment, business reason for expense

We suggest that you maintain records of your expenses with the required documentary evidence referenced above in a log or expense statement. While recording each expense through a book, log, or expense statement will be redundant with keeping copies of all your receipts, it will provide an efficient way to transfer your expenditures from receipts onto your tax return, and in the event of an audit, you will have an easier time of defending the deduction.

Why should I seek reimbursement from my employer for my expenses?

If a reimbursement policy exists, you must seek reimbursement from your employer; you may not deduct reimbursable expenses. Further, reimbursement is more favorable because the burden of proof is transferred from you to the business upon audit and the potential loss of deduction due to the 2% AGI phase out and AMT (for employees) are avoided. Should you claim any expenses not reimbursed by your employer, you must be able to show that either a reimbursement policy does not exist or the amount of the expenses reimbursed is limited pursuant to employer policy.

Please note that once an employer has reimbursed you for an out-of-pocket expense, it cannot be claimed as a deduction on your personal tax return.

Aronson & Company is available to consult with your company about the establishment of an effective employer reimbursement policy or with employees seeking reimbursement or tax breaks for out-of-pocket business expenses.